The Federal Financial Triangle

May 2, 2013

Before the Federal Reserve Act of 1913, hundreds of national banks in towns and cities across the United States were issuing dollar bills. In 1913, the Federal Reserve was created as America's central bank to control the issuance of paper money. The Federal Reserve, now a huge investor in real estate loans, props up the U.S. Treasury which backs Fannie Mae and Freddie Mac, the mortgage originators who guarantee the real estate loans the Federal Reserve buys. The arrangement creates a financial triangle between the three actors that needs to be examined, says Alex Pollock, a resident fellow at the American Enterprise Institute.

The Federal Reserve owns more than $1.1 trillion in mortgage-backed securities, which are guaranteed by Fannie Mae and Freddie Mac, the same government-sponsored enterprises that collapsed during the 2007 financial crisis.

Following their collapse, Fannie Mae and Freddie Mac were given new capital by the U.S. Treasury, which gives the mortgage guarantors infinite leverage.

The potential for trouble is created because the U.S. Treasury gets much of its money from the Federal Reserve, which also holds more than $1.8 trillion in Treasury debt.

The Fed, by buying long-term mortgage-backed securities and long-term Treasury debt, is creating interest rate risk on its own balance sheet, which is leveraged more than 60 times the size of its equity. The Fed's balance sheet has $3.3 trillion in total assets and $55 billion in equity.

If, and eventually when, interest rates rise, the Fed will have to stop buying because its assets will depreciate.

An interest rate hike of 2 percent would trigger the Fed's $1.1 trillion portfolio to lose about $169 billion in market value, and in the long-term cause the Fed to take losses of an estimated $285 billion on its Treasury security portfolio.

When rates rise, many of the underwater investments might need to be sold, which could result in the Fed having a negative market-to-market net worth of $206 billion.

It is unclear what it would mean for the world's principal central bank to have negative net worth. Luckily for the Fed, it controls its own accounting so regardless of what happens in the future it will always have a positive capital.